Clear Eyed Capitalist

Archive for May, 2010

In the last month I have listened to two manager reports for some traditional private equity funds. I find myself ruminating about the structure of capital markets and how multi-layered they are.

The first call I listened to was for an international fund-of-funds. It was really interesting and even a little bit intimidating. It’s almost a stock-trader view of the world but from a next level up – As a fund-of-funds, their level of focus is on the marketplace of company valuations: entry and exit multiples (of EBITDA or Earnings Before Interest, Depreciation & Amortization… one common view of the value a company generates). They compare private market multiples to public market multiples and the gap between the two. So it’s much like stock analysis but instead of looking at P/Es they talk about EBITDA multiples. (IE this company got bought for 1.5x EBITDA, then got sold some years later for 2.3x EBITDA) They look at availability of investment capital (“market participants report high valuation due to significant dry powder in Indian PE market and strong public market recovery.”), They look at the availability of debt financing. They look at examples of exits and what the returns on those have been. One speaker commented that “public market competition for buyouts creates valuation pressure.” To translate – a well functioning IPO market raises the cost of buying companies because they have an alternative exit opportunity for their investors, so buyers can’t set price as easily. That suggests to me that our poorly functioning IPO market creates better buying opportunities for large corporations because growing companies have fewer alternatives.

Sources of investment capital, as well as activity in exits, were categorized as “buyout” “growth” “venture”. They also note PIPE (private investment in public equity) financing as a significant (16-25% of total financing over the last 5 years) source of investment capital. I’m not sure if there are PIPE-focused funds, I didn’t notice any in their report. This fund has done co-investments so they’re doing some direct deals.

For opportunities they look at countries and macroeconomics – GDP growth, consumer spending, net exports, inflation, government interventions. In China, domestic IPOs are becoming a leading exit opportunity for Chinese companies on Shenzen SME board and ChiNext. The government is also forming policies more friendly to foreign capital.

The intimidation comes in because I realize that this is a perspective and information flow that really understands later stage round valuations. Those valuations are essentially entry multiples for these funds who will grow companies more before looking for eventual exit opportunities. They are tracking those entrance & exit valuations as a market. As an angel investor looking to invest in companies that might eventually get bought out to give my money back, I’m feeling like somewhat of a doofus to be making investments with no clue as to those larger market forces which will totally shape my own markup/down/exit opportunities. What would really help me is to have quarterly calls with a fund like this one that is invested in US markets, in the same kinds of companies I want to invest in.

I also recently attended a meeting for a private equity fund. This fund invests in companies at a later stage, grows them, and perhaps at one time a fund like this might have taken them to IPO, but this company seems to get “realizations” (IE money back out) through a mix of a couple IPOs, some additional investments from other capital players, and some complete sales to another larger entity.

The combination of these meetings really has me visualizing the current capital market space as a complex food chain – perhaps not unlike how I’m learning that beef cattle are brought to market. Cows are born in a “cow/calf” operation and raised until they’re weaned. Then they have a “stocker” stage where they’re raised until 600 or 800 lbs and that can often happen at a different farm. Then they’re “finished”, which for commodity beef usually happens at a feedlot – they’re fattened up with grain. (This is where “grass-fed-beef” comes in, instead they’re finished on grass.) Then they’re sold to a packer who slaughters & butchers. All different stages, often all different ranch operations adding value (weight) to the same cow. In the corporate world, these layers are an intermingled mix of venture, private equity, and buyout funds, with larger corporations and, decreasingly, the IPO markets playing packer.

If this is a reasonable metaphor (though I’ll hazard a guess that the stages & players in the beef market are a little better delineated than those of the capital markets, simply by the process being older) then this poses serious challenges for bringing any business to scale, especially a socially conscious business. Growing beyond a regional business means you need a pipeline of these later pastures. If you’ve started out with your first layer of the capital markets being a CDFI funder or an angel group, what are the odds you’ve got connections into the next layer? I now know of a few social-impact focused venture or early-stage private equity funds, but we’re missing the buyout funds that can play stocker or finisher.

At any level, smart investing is going to require being aware of who the next stage in the pipeline might be. At the angel level, to build real-economy businesses, I think we need more focus on building regional businesses and exiting via cashflow. To-date I’ve seen ONE deal with this focus out of several hundred. J-curves that can exit without all this capital infrastructure are for intellectual property businesses like software and biotech that can have 90% net margins, the rest of us need to get the stars out of our eyes and focus on the business of business.